Leverage & Margin. Basic Forex terms

What is leverage?

The leverage is sort of a loan that the broker offers which allows the trader to place transactions higher than the actual balance of the account.

Example:

With 1:100 leverage, a trader can operate US$100 with only US$1 (this is just an example and I dont recommend to do this). The same way, to trade 1 standard lot (100,000 units) you will only need US$1,000.

Then, knowing this, how many USDollars you should have in your account if you want to buy 5 lots and the broker is giving you 1:50? You need at least US$10,000.

If 5 lots are equivalent to 500,000 units, and you require 50 times less, then you need $10,000.

How does it works?

We could say that the leverage is some type of a loan from the broker to the trader (this is only for reference to make the concept clear. Nothing to do with a loan). Lets suppose that Steve has a US$1,000 account and his broker is giving him 1:100 leverage. Steve can make a trade of 1 standard lot. He will be investing the US$1,000 and the other US$99,000 its placed by the broker.

The US$1,000 are retained in the trade until Steve closes.

Now that we know what the leverage is about, we upgrade to the next level and we can step on more advanced concepts.

MARGIN

The margin is the amount of money that the trader place in a certain position. This might not be clear but its very related with the leverage. To explain this we will suppose that there is no leverage or we have 1:1 leverage, which is the same. In this scenario, if the trader wants to buy 1,000 and the EUR/USD current exchange rate is 1.4253, them how much money does the trader invest?.

The answer is 1000, the same amount that he’s buying, and when making the conversion to USD it is $1,425.30 (1000×1.4253).

If the trader has in the account $5,000, $1,425.30 are taken to open such position at the market. When the broker receives the order to buy 1,000, takes $1,425.30 from the traders account and the transaction is placed in the market. The $1,425.30 are known as “used margin” or just “margin”. The margin is not discounted immediately from the trader’s account but it is retained and is not reflected as balance until the trade is closed.

Now, lets suppose that the same trade is open, but this time there is a leverage of 1:100. This means that now the trader has to invest 100 times less (0.01), so the margin is 1,425.30×0.01= $14.25. This means that, in order to buy 1,000 its only needed $14.25.

If, instead of 1,000, the trade its opened with 1 standard lot (100,000 units), how much margin will take place in the trade?

To find out, let’s follow the steps:

Buy 1 lot of EUR/USD = 100,000EUR against USD

Exchange rate EUR/USD: 1.4253

1 Lot = 142,530.00 USD

100:1 Leverage

Margin: 142,530.00/ 100 = 1,425.30 USD

In the previous scenario, it’s needed $1,425.30 as margin in order to obtain a 1 standard lot trade with the EUR/USD at 1.4253 exchange rate.

BALANCE

This is a very simple concept. The balance is the existing money of the account without the money of the open positions. In other words, if there are no open trades in the account, the balance is the same amount of money of the account.

The balance its only modified when the trades or positions are closed, but not when these are opened.

For example: in the account there is an initial balance of $1,000 and a trade its opened that its using $1,000 of margin. The balance remains as $1,000 and when the trade closes, the profit or loses will be added or removed. During the time that the trade is open, the used margin is not available to open new trades. This is due to the capability to open new trades doesn’tt depend on the balance but in the free margin. This concept I will explain it later.

EQUITY

When we have open positions, the balance is not that important as it is the equity. We get this, by adding or subtracting profits or losses to the balance. These profits or looses its what we call Drawdown and its value changes with every single movement of the exchange rate of the currency pair we are trading.

For example:

We have many open trades and the total is $1,500, the equity will be the balance plus $1500. In the other hand, if we have a negative drawdown of $1,500, the equity will be the balance minus $1,500.

If there are no open trades in the account, the balance and the equity have the same value.

Free Margin

The Free Margin its the difference between the equity and the total of the margin, in all the open trades.

Free Margin = Equity  Margin

If we dont have open trades, then no money will be used as margin. All the funds in the account are available. In other words, if we dont have any trade, the balance, the equity and the free margin will remain with the same value.

For example: Let’s say we have an account with $1,000 and we have a total of $250 used as margin with the open trades and the drawdown is positive with $150. Which one is the balance, equity and free margin?

Balance: $1,000

Equity: $1,000 + $150 = $1,150

Free Margin: $1,150 – $250 = $900

Margin level

What we can notice in the previous formula, when the Margin Level its 100%, then the equity and the balance have the same value. This is a very delicate situation because it means that the balance you have inside as trades, its all the balance you have available, including the possible profits of the open trades. There is no more free margin available so, there is no way for you to open new trades. When you reach this stage, this is what we call Margin Call.

The technical level of Margin Call is when the margin reaches 100%, but the trading conditions of each broker can get you to hit the Margin Call at different levels. Most of the time its at 100%.

Lets suppose we have a $20,000 account and we have an open trade with $2,000, in other words, we have a margin of $2,000. If this trades goes negative, down to $18,000, that means that the equity will be $2,000, just as the margin. Therefore, the margin level is 100%. There is no free margin anymore and we cannot open new trades, we can only close the current open trade, losing the $18,000 and keep the $2,000. Or we can stay in the market waiting for a reversal of the market, but, what happens if it keeps going against us?

If the market keeps moving against our trade, there will be a stage where the broker will be forced to close the open and highest trades. The level where the broker does this its called Stop Out. The stop out level may vary depending on the broker, it can go from 5% up to the 50% or more. Thats why you should always read the brokers contracts and trading conditions. Most of the time, the trades are closes automatically when the account reaches the Stop Out and starts closing the trades with higher losses. This is in order to take the account out of the Stop Out level and let it breathe a little. Every time a trade closes, it releases a portion of the margin.

Why does the broker closes my trades?

Almost every trader that has have a Margin Call, has gotten a trades closed and always blame it on the broker. Thats the easiest thing to do, blame it on someone else.

But the truth is that the margin call its totally normal. The broker can not allow the clients lose more money than the one they have in their accounts. If so, they have two options, either charge the client the losing amount or take over the loss. The market could go against the trader with more losses and there is no broker willing to take that loss.

When you have pending orders and the market reaches the execution price of the order, but there is no more free margin left, then the pending orders will be automatically canceled. There are some brokers that they dont cancel the order but there is no execution either and if the market returns to that level and if there is enough margin, then executes normally.